Reeves must raise tax and cut spending, markets say

UK Chancellor of the Exchequer Rachel Reeves is walking a tightrope as the crucial Autumn Budget approaches, as pressure mounts to appease voters, shore up the public finances and convince money markets that her policies are sound.

Reeves has been left scrambling to find strategies to close the multibillion-pound gap in the public finances when he announces the budget on November 26, thanks to self-imposed fiscal rules he has doubled down in recent weeks.

This means drastically cutting spending or breaking the manifesto pledge not to raise certain taxes; or a combination of the two.

CNBC takes a look at some of the options on the table.

According to recent reports from local media outlets, the finance minister is considering various ways to support public finances. taxation of dividends, Cutting tax breaks for salary sacrifice schemes And Higher taxes on some professions.

Any move to increase taxes will be unwelcome.

One September YouGov poll of more than 6,500 Brits Nearly one in three adults believe Reeves should refrain from increasing taxes in the budget, even if it means cutting spending or taking on more debt. A separate YouGov poll found more than half of 3,980 British adults believed the government should prioritize keeping its promise not to raise taxes over Reeves’ promise not to increase borrowing.

But some in the money markets would welcome tax increases. Gold sold off on Friday as investors reacted to reports that Reeves would make a U-turn on income tax increases planned as part of the budget.

“How can this announcement stimulate growth while simultaneously having to cut spending and increase the tax burden to keep bond investors happy?” Toni Meadows, chief investment officer at BRI Wealth Management, told CNBC at the time.

Brian Mangwiro, managing director of global sovereign debt and currencies at Barings, told CNBC that his team expects Reeves to announce some kind of tax increase in the budget later this month. Mangwiro said the move would be positive for UK government bonds (also known as gilts).

Barings is taking a constructive stance on gilts against an environment where the job market is loosening, wage growth is moderating, inflation is expected to peak and the Bank of England is assumed to continue cutting interest rates until 2026.

“A fiscally responsible Budget will create additional headwinds,” Mangwiro said by email. While Mangwiro argued that the UK’s tax burden will probably reach new records, he said he expected financial markets to benefit from new or increased taxes.

“Given the government’s pro-growth agenda, we expect additional revenues to be directed to investments,” he said. “We hope this will increase UK productivity in the medium term.”

Stuart Edwards, who runs Invesco’s Tactical Bond Fund, also believes Reeves will deliver a “market-friendly” Budget on November 26.

“Chips in the UK are lining up for a more bond-friendly environment,” Edwards said at a recent fixed income roundtable. Edwards said the government and financial authorities in the UK were now “aware of the situation” and needed to “act sensibly” on public finances.

“They don’t have the bandwidth to play fast and loose,” Edwards said.

The UK gilt market has been hit by periodic volatility and uncertainty since former Prime Minister Liz Truss’s mini-budget in September 2022. “The gilt market was volatile,” Edwards said. “But there was value in the gilts, there’s a lot of risk premium embedded in the gilts.”

Many bond investors who spoke to CNBC said they would like to see Reeves combine tax increases with spending cuts. increasing public deficit under control.

“Gilt markets need to see real fiscal consolidation delivered in a way that doesn’t hurt growth. It’s a difficult balance,” said Emma Moriarty, portfolio manager at CG Asset Management in London.

Moriarty said some of that should be achieved through broad-based tax increases that take effect immediately; but Moriarty said it was crucial that these were paired with “meaningful cuts” in spending.

The Autumn Budget comes as Reeves seeks to plug a financial black hole estimated to be as high as £50 billion ($65.6 billion).

Cutting spending too drastically is also unlikely to get much support from the ruling Labor Party’s more left-leaning MPs; Reeves’ rebellion against a previous attempt to cut the county’s welfare bill caused the reforms to be watered down over the summer.

“Plugging a black hole of the current size entirely through taxation has the potential to weigh on economic growth for a period of time, not only through the direct impact on disposable income, but also through more subtle behavioral effects on the household savings rate and the level of private investment, both of which have been issues in the UK for some time,” Moriarty said. he said.

“There’s a lot of good news already priced into the gilt markets,” he added, noting that gilt yields have fallen substantially across the curve over the past month.

“Most of this will be due to positive sentiment in US bond markets, but some will also be due to rising market expectations. [Reeves] We will take meaningful steps to improve public finances. So there is great potential for these high expectations to be disappointed.”

Even so, Barings’ Mangwiro said markets were likely to be disappointed. “Given the political sensitivity, we do not expect the Chancellor to announce significant spending cuts,” he said.

Another option for Reeves is to break his own fiscal rules, which call for day-to-day government spending to be financed by tax revenues rather than borrowing, and for public debt to fall as a share of economic output by 2029-30.

However, after using it, this seems unlikely. In a surprise pre-budget speech last week, he reiterated his “firm” commitment to those rules.

While bond yields reflect the borrowing costs of the governments that issue them, It can also affect mortgage rates, investment returns, the wider economy and personal borrowing.